VI. DEBT SECURITIES

1. VI. DEBT SECURITIES

2. A. Bonds Defined as debt obligations issued by government, governmental agencies, and corporations Par � Face value (usually $1,000, quoted as a percentage � 100 or more or less) � bonds are issued at par, but the market value of a bond can be more or less than par Discount � When a bond sells for less than par Premium � When a bond sells for more than par Coupon � The annual interest rate paid as a percentage of par. Bonds generally pay semi-annually (twice per year), at one-half of the coupon rate per payment (originally, coupons were attached to the physical bond certificate, then �clipped� and presented to the corporation for payment

3. A. Bonds Interest Rate � The fixed percentage of par paid annually (in two payments) to the bondholder Bondholder � An individual or institution that purchases bonds, becoming a creditor of the corporation Issuer � The government, governmental agency, or company that sells the bond Maturity � Date upon which the issuer of a bond must return the original principal amount of the bond plus the final interest payment to the bondholder Floating an Issue � The government, governmental agencies, and corporations issue bonds with a set coupon, and, based upon demand, may issue more

4. A. Bonds Indenture � The legal agreement governing the terms of the bond issue Book Entry Bond � A bond that is registered electronically, with no physical certificate issued Bearer Bond � Has no investor name when it is issued, whomever possesses the certificate has a right to receive interest payments and repayment of principal Secondary Market � Similar to a stock exchange, where bonds are bought or sold by brokers � the money for purchase or sale goes to the seller or purchaser, like stocks, bonds bought on the secondary market do not provide any additional funds to the issuer

5. A. Bonds Types of Bonds Government Securities Treasury Bills � Issued by the United States government, backed by the full faith and credit of the United States government � the safest security, matures in 26 weeks or less, sold at a discount and matures at par Treasury Notes � 2, 3, 5 and 10 year maturities, pay interest every six months (semi-annually), with a fixed coupon Treasury Bonds � 10+ year maturities, pay interest semi-annually, fixed coupon

6. A. Bonds Strips � Created by broker-dealers, consist of bonds sold at a discount with no interest payments Treasury Inflation Protected Securities (TIPS) � Have a semi-annual fixed rate coupon, with par (face) value adjusted twice per year based upon changes in the Consumer Price Index Municipal Bonds � Issued by state an local governments and governmental agencies, may not be as credit worthy as Treasuries, generally exempt from federal income tax and from state taxes for purchasers who live in the state of issue

7. A. Bonds Agency Securities � Issued by government sponsored entities, implicitly backed by the issuing government, but explicitly backed by the issuing agency � provide higher yields than direct government securities, with somewhat higher risk InterNotes Prospectus http://www.mta.info/mta/investor/pdf/pdf/MTA-Tr_Rev_2005D_10-30-08_Final.pdf

8. A. Bonds Corporate Bonds � Debt securities issued by corporations, have a greater claim on the firm�s assets than equity instruments, backed only by the issuing company, with risk quantified by rating agencies Commercial Paper � Similar to Treasury Bills, issued by corporations at a discount, with a maturity of 90 days or less

9. A. Bonds

10. B. Other Types of Debt Securities Money Market Funds � Short term investments consisting of a pool of short term debt securities, �marked to market� daily so that face value ($1.00) never changes, but interest yields change daily Asset Backed Securities � Debt obligations backed or �collateralized� by other forms of debt Government agency asset backed securities � Consist of �pools� of mortgages, with repayment of principal and interest guaranteed by the full faith and credit of the United States government Welcome to Ginnie Mae , http://www.ginniemae.gov/investors/ocs_pdf/2008-088.pdf REMIC Definition

11. B. Other Types of Debt Securities Quasi Governmental Agency Securities � Issued by corporations originally organized as governmental agencies, with the implicit understanding that repayments of principal and interest are guaranteed by the federal government Debt Securities: Understanding Fannie Mae Debt: Introduction to Fannie Mae Debt Securities Collateralized Mortgage Obligations � Backed by �pools� of mortgages, can be issued by GNMA, FNMA, FHLMC, or by investment banks http://www.freddiemac.com/mbs/docs/investors_guide_CMOs.pdf Certificates of Automobile Receivables � Backed by pools of car loans Presale: AmeriCredit Automobile Receivables Trust 2008-1 - 2008/10/06 - S&P Credit Research - AlacraStore.com

12. B. Other Types of Debt Securities Certificates of Deposit (CDs) � Issued by banks, fully federally insured through the FDIC up to $100,000 per person or corporation per bank Annuities � Issued by insurance companies, designed to provide retirement income � provides a future stream of monthly payments for investment of a lump sum, often with a fixed interest rate � the dollar value of payments varies depending upon the assumed interest rate Guaranteed Investment Contracts � Issued by an insurance company with a guaranteed interest rate and a specific term (similar to a bond), however, not marketable

13. B. Other Types of Debt Securities Hybrid Securities Preferred Stock � An equity security with a specified, obligated dividend payment rate with no specific maturity � does not have the voting rights of common shares Convertible Bonds and Convertible Preferred Stocks � Pay regular dividends or interest, but can be exchanged for a set number of shares of common stock at a set price

14. C. The Yield Curve and Interest Rates Maturity � The term of a bond � the period after which the fixed income security must return principal and accrued interest to the purchaser Short term = 1 year or less Intermediate term = Greater than 1 year through 10 years Long term = Greater than 10 years Yield to Maturity � A measure of rate of return adjusting for both the selling price of the bond (discount or premium from face value) and the bond�s interest coupon rate

15. C. The Yield Curve and Interest Rates Generally, the longer the term of a fixed income security, the greater its interest yield and/or yield to maturity The yield curve changes constantly, and can be a predictor of economic activity http://www.smartmoney.com/onebond/index.cfm?story=yieldcurve If interest rates in the market are greater than the coupon rate of a debt security, that security will sell at a discount � if market interest rates are lower than the coupon rate of a debt security, that security will sell at a premium

16. C. The Yield Curve and Interest Rates Capital Appreciation (Depreciation) � Gain or loss in a fixed income security�s market value due to market interest rate changes Duration � A formula accounting for a debt security�s interest coupon and its term to maturity The higher the coupon interest rate, the shorter the duration for fixed income securities of a similar term to maturity The lower the coupon interest rate, the longer the duration for fixed income securities of a similar term to maturity The longer the duration of a fixed income security, the more volatile the security�s price (similar to maturity � the longer the maturity of a fixed income security, the greater will be its price volatility

17. C. The Yield Curve and Interest Rates Buy and Hold � Purchasing bonds with no intention of selling them, bonds are held to maturity to avoid capital gains and losses Riding the Yield Curve � Purchasing bonds at the �long end� of the yield curve, holding them until they become short term securities, then selling them for a capital gain Bond Laddering � Buying bonds with different maturities, then reinvesting the proceeds at maturity into longer term securities

18. D. Risks of Fixed Income Security Investing Inflation Risk � Inflation increases to a rate greater than the fixed income security coupon, decreasing the market value of the security, and penalizing investors for purchasing fixed income securities Reinvestment Risk � The risk that the investor will not, upon maturity and/or upon coupon payment dates, be able to obtain a yield as great as the coupon rate of the fixed income security

19. D. Risks of Fixed Income Security Investing Risk of Capital Loss � If a sale is required before maturity, investor is �locked in� until maturity to realize par value, or, if interest rates rise, there may be a capital loss upon liquidation Default Risk � The issuer may become unable to make interest payments to bondholders and/or to repay bond principal upon maturity � for lower quality bonds, the price depends more upon changes in the firm�s credit rating than upon prevailing interest rates

20. E. Valuing a Bond Discount or Premium � The price paid for a bond either less or greater than par (100), based upon market interest rates at the time of purchase Coupon Yield � Based upon par value, the interest paid per year as a percentage of par Current Yield � Annual Interest Price Paid Based upon the market price of a bond, may be higher or lower than the coupon yield depending upon market interest rates

21. E. Valuing a Bond Yield to Maturity � Money gained or lost when a bond matures at par (versus price paid), plus interest, plus interest on interest Ex. � Bond has a 6.0% coupon, with 5 years to maturity � buy at par and hold to maturity Bond pays $30 (on $1,000 face) 2x per year = 10 payments = $300 over 5 years Buyer receives $1,000 on maturity, plus $300 interest $1,300 less cost ($1,000) = $300

22. E. Valuing a Bond Ex. 2: Same coupon, same date of issue, but purchased 2 years after issue when market interest rates for three year bonds with a similar rating are 8.0% Price = 94.76 (94.76% of par) based upon market yield to maturity � after 3 years, the investor receives: $180 coupon payments ($30, 2x/year, 6 periods) $1,000 face $1,180 less $947.60 (price paid) = $232.40 Note: If the investor had purchased an 8.0% coupon bond at par, the interest yield would have been $240 over 3 years

23. E. Valuing a Bond Ex. 3: Same coupon, same date of issue, but purchased 2 years after issue when market interest rates for three year bonds with a similar rating are 4.0% Price = 105.60 (105.60% of par) based upon market yield to maturity � after 3 years, the investor receives: $180 coupon payments ($30, 2x/year, 6 periods) $1,000 face $1,180 less $1,056 (price paid) = $124.00 Note: If the investor had purchased a 4.0% coupon bond at par, the interest yield would have been $120 over 3 years

24. F. Buying and Selling Bonds Price depends upon interest rates � when interest rates fall, bond prices rise; when interest rates rise, bond prices fall Bonds are not as liquid as major company stocks � it is a smaller market, and there is not always a buyer for a seller of bonds on the market Bid � The price that a buyer offers Ask � The price that a seller wants Spread � The difference between bid and ask Markup � Dealer commission charge � can be as much as 4.0% to 5.0% -- Treasury markups are generally less than 0.5% for large orders, as the market is large and highly liquid, bonds that are lower rated and/or small positions have a higher markup

25. G. Bond Variations Bonds That May Provide Lower Returns to Investors Callable Bonds � Can be redeemed by the issuer prior to the stated maturity Call Schedule -� A list of dates and prices at which bonds may be redeemed, or a date after which a bond may be called at any time Market Interest Rates and Bond Calls � If the bond provides a coupon yield greater than market interest rates, it is likely to be called; if the coupon yield is less than market interest rates, it is not likely to be called

26. G. Bond Variations Sinking Fund � Bonds are issued with a �pool� of money set aside (and/or paid in annually) by an issuer to redeem bonds at call or upon maturity � provide lower yields, but are more safe as there will be money available to repay purchasers

27. G. Bond Variations Bonds With Conditions Subordinated Bonds � Have a lower claim on assets than other debt issues Senior Bonds � First in line against corporate assets Floating Rate Bonds � Provide periodic adjustment of bond interest payments Prefunded Bonds � Bonds whose repayment is guaranteed by another bond issue � proceeds of other issue may be invested in Treasuries, which can be sold to redeem prefunded bonds

28. G. Bond Variations Insured Bonds � An insurance policy backs payment of principal and interest Bonds with Equity Warrants � Corporate bonds which include a right to buy the issuer�s stock at a specified time and price Put Bonds � Bonds that may be tendered for redemption at par prior to stated maturity

29. G. Bond Variations Bond Alternatives Convertible Bonds � Can be changed into company stock at a price and quantity set upon issue, upon a date specified at issue, or upon maturity Generally subordinated debentures Generally have call provisions limiting returns if the firm�s stock price increases

30. G. Bond Variations Zero Coupon Bonds � Issued at a discount, mature at par, with accrued interest and issue price adding up to par Price Volatility � Have a longer duration than coupon paying bonds, and thus greater price volatility than coupon paying bonds of the same maturity Taxes are due annually on accrued interest